## _wp05187

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---

### I. Introduction — scope and central questions
- Focus: de facto (unofficial) dollarization defined as holding by residents of assets and liabilities denominated in a foreign currency that does not enjoy legal tender status.
- Emphasis:
  - domestic dollarization (onshore deposits and loans) rather than external dollarization;
  - asset-liability dollarization rather than currency substitution.
- Motivations:
  - FD has increased or remained stable despite declining inflation rates.
  - Dollarization complicates policy responses in crises and can be a source of financial vulnerability.
  - Shift from fixed to more flexible exchange rate regimes highlights prudential consequences of exchange rate risk.
- Central policy questions:
  - How much do we know about causes and dynamics of de facto dollarization?
  - Should countries: aggressively seek to de-dollarize; accept dollarization and limit its downsides; or fully (officially) dollarize?
- Tactical agenda for further discussion:
  - how (and how aggressively) to de-dollarize;
  - how to conduct monetary policy in a dollarized economy;
  - how to implement prudential reform;
  - how to promote local currency markets.

### II. Theories of Financial Dollarization — conceptual frameworks
- FD as an equilibrium outcome driven by currency composition choices in loan/contracts; driven by risk differences.
- Three conceptual categories:
  - The Price Risk–Portfolio Paradigm (portfolio/CCAPM approaches).
  - The Credit Risk Paradigm (perfect/imperfect information, moral hazard/prudential regulation).
  - The Financial Environment (market size, integration, market and legal imperfections).

### A. Price Risk–Portfolio Paradigm — mechanisms and implications
- Core mechanism: uncertainty of real returns (price risk) drives currency choice under risk aversion; CAPM and CCAPM variants.
- Key implications:
  - Currency choice depends on relative volatilities: dollar preferred if real exchange rate is stable relative to inflation, or if dollar real interest rates are more stable when rebalancing costs exist.
  - Monetary policy that fails to stabilize inflation or targets the real exchange rate can stimulate dollarization.
  - FD should increase with openness and real dollarization (dollar pricing) due to higher pass-through.
  - Expectations and credibility matter: lack of credibility induces persistence (hysteresis) in FD.
  - CCAPM adds a safe-haven effect: consumption–exchange rate correlations can tilt investors toward dollar; sudden stops/political disturbances strengthen dollar preference.

### B. Credit Risk Paradigm — channels and policy lessons
- Perfect information:
  - Creditors internalize credit risk; debtors prefer currency minimizing expected bankruptcy costs.
  - Dollar chosen when devaluation probability is small but peso premium makes peso loans costlier (interest-rate-induced credit risk).
  - Pegs and "fear of floating" can increase nominal peso rates and interest-rate risk, strengthening dollar dominance.
  - Policy takeaway: more exchange rate flexibility and reduced liquidation costs can reduce FD.
- Imperfect information:
  - Creditors cannot observe borrowers’ currency exposure; strategic choices can produce corner solutions (full dollarization or full pesification).
  - Market failures (coordination, information) imply marginal reforms may be ineffective.
- Moral hazard and prudential regulation:
  - Deposit guarantees, bailouts, and foreign liquidity support create option-like incentives favoring dollar intermediation.
  - Currency-blind prudential regulation and failure to reflect currency mismatch in capital requirements further favor dollarization.
  - Policy takeaway: ensure risks are internalized via currency-sensitive prudential requirements.

### C. Financial Environment — structural determinants
- Size and integration:
  - More open and internationally integrated countries should be more dollarized; small countries may be especially dollarized.
  - Empirical links: size matters for external FD but not consistently for domestic deposit dollarization.
- Market and legal imperfections:
  - Offshore intermediaries, liquidity risk, transaction costs, network effects, benchmark practices favoring major currencies, and superior offshore creditor rights all enhance dollar attractiveness.
  - Policy implication: leveling the playing field, improving legal and regulatory frameworks, and promoting local currency markets can justify government intervention, though hysteresis and market-size constraints complicate transitions.

### III. Empirical evidence — support for paradigms and key findings
- MVP-based (portfolio) evidence:
  - MVP explains a significant share of FD at the expense of inflation rate in cross-country studies, but not all FD.
  - Trade openness often insignificant in static cross-country regressions; pass-through correlates with FD but elasticity < 1, implying MVP explains only part of FD.
  - Long-sample MVP measures outperform recent-sample measures, indicating expected volatilities/credibility matter.
- Evidence consistent with corner solutions and credit-risk channels:
  - Positive statistical link between dollarization and fear of floating (directionality not established).
  - Asymmetric/skewed nominal exchange rate distributions can explain dollar dominance.
  - Negative correlations between exchange rate and output in highly dollarized economies support credit-risk and safe-haven channels.
  - Large borrowers tend to be more dollarized (coordination failure hypothesis), with alternative explanations possible.
- Prudential/moral hazard evidence:
  - Currency-blind prudential regulation correlates with greater FD.
  - Restricting or eliminating LOLR induces banks to hold more liquidity.
  - Evidence on capitalization and dollar intermediation is limited.

### IV. How concerned should countries be? — monetary effectiveness and balance-sheet risks
- Monetary policy effectiveness:
  - FD has not prevented inflation stabilization when exchange rate acts as a flexible anchor; FD remained high despite lower inflation.
  - FD is associated with higher exchange rate pass-throughs, which can limit monetary policy flexibility and countercyclical capacity.
  - Interest rate transmission is diluted when intermediation is predominantly in dollars; monetary policy can still operate via the exchange rate, but large moves can harm borrower balance sheets.
- Balance-sheet effects and crisis propensity:
  - FD raises prudential concerns: local-currency value of dollar liabilities can outpace asset/income values, triggering corporate/banking crises, sudden stops, and output volatility.
  - Empirical associations: dollarized countries have more fragile corporate sectors and banking systems; greater exposure to contractionary devaluations, devastating sudden stops, public debt crises, and banking crises; higher output volatility.
  - Net effect: FD increases crisis propensity and can limit effectiveness of countercyclical monetary policy in large shocks.

### V. Market-driven de-dollarization — principles, instruments, and sequencing
- Two main fronts:
  1. Revise regulation to internalize risks of dollar intermediation and expand monetary policy room.
  2. Promote use of peso and peso-based substitutes to the dollar.
- If FD approximates MVP (interior solution):
  - Improving monetary credibility should reduce dollarization.
  - Policy focus: institutional and capacity building for central bank independence and sound monetary policy.
- If FD exceeds MVP (corner solution):
  - Transparency improvements may help marginally, but high correlation of default and devaluation makes switching regimes insufficient alone.
  - Prudential reform aimed at banking resilience (e.g., tighter norms on dollar loans to nontradable sector) should prioritize immediate financial stability rather than altering FD.
  - Transition risks: raising prudential requirements can induce disintermediation or migration to offshore/dollar channels; regulatory arbitrage must be anticipated and addressed.
- Instruments and sequencing to promote peso use:
  - Improve monetary management (procedural changes to stabilize peso interest rates and increase transparency).
  - Refocus public debt management toward peso-denominated instruments to deepen local currency markets.
  - Price indexation as an intermediate step:
    - Indexed pesos (real rates) can bridge from dollars to pesos by eliminating inflation-expectation component of peso premium at longer maturities.
    - Limitations: indexed pesos may fall in value upon currency adjustment (backward-looking indexation), have limited liquidity in crises, and require substantial public-debt-management support and a radical monetary-policy switch (e.g., to free float) and active regulatory policies to succeed.
- Prudential guidance during transition:
  - Prudential norms should reflect the actual regime; imposing alternative-risk-based capital/limits without regime credibility risks inappropriate distortions.
  - During constrained monetary regimes, prudential requirements may need to be raised for both peso and dollar exposures to preserve stability.
  - Authorities should design measures to prevent regulatory arbitrage and profitable shifts to offshore/dollar intermediation.

### VI. Should countries fight dollarization frontally? — options, risks, and historical lessons
- Direct measures: limits on dollar deposits or loans, taxes on dollar intermediation, forced conversion.
- Potential benefits: can "speed things up (and hence reduce transition costs) by cutting through the policy coordination maze."
- Risks and historical experiences:
  - Forcing agents to use a currency they distrust risks heavy disintermediation or risk shifting; runs on deposits; capital flight and off-shore dollar intermediation (Mexico 1982; Bolivia and Peru in the 1980s).
  - Some recent compulsory conversions (Pakistan, Argentina) are too recent to judge but may facilitate later local-currency intermediation growth.
  - Empirical counterpoint: legal restrictions on dollarization have effects that can be beneficial; link between dollarization and financial deepening is negative in some studies.
- Policy trade-offs:
  - Gradual approaches ("putting sand in the wheels") are less risky but may yield meager results.
  - Forceful approaches may be warranted when backed by strong policy commitment and political consensus; credibility should ideally be enhanced prior to drastic measures.

### VII. Regime choice: live with FD, bi-currency, or de jure dollarization
- When to give up:
  - Small, narrow-market, highly tradable economies with low central bank credibility and limited technical resources may find radical reform too costly.
  - Bi-currency regime (currency board) as intermediate option:
    - Advantages: retains seignorage, allows adjustment speed via crawl, can limit output volatility when inflation is low.
    - Costs: continued dollarization retains financial stress risks; requires prudential buffers.
  - De jure dollarization:
    - Also requires buffers.
    - Advantage: limits scope for "forced" devaluations from self-fulfilling twin crises; may reduce interest rates and exposure to liquidity crises.
    - Appropriate when part of an optimal U.S. dollar currency zone or when monetary credibility and financial stability options are exhausted.
- Policy guidance:
  - De jure dollarization preferable when welfare and vulnerability trade-offs favor irrevocable reduction in currency risks.
  - Bi-currency regimes useful until clearer currency-area membership emerges.
  - "Learning to live with FD" is viable when credibility cannot be improved: build sufficient prudential buffers so exchange rate flexibility can be used without excessive financial stress.

### VIII. Conclusions and policy recommendations — diagnostic-led, tailored strategies
- Overarching conclusions:
  - Dollarization is not unavoidable or inconsequential; countries need a comprehensive, well-coordinated policy agenda tailored to the type and extent of dollarization and their macroeconomic, institutional, and structural constraints.
  - Some dollarization can be desirable; countries with credible monetary policies may liberalize dollar accounts for efficiency under a suitable prudential environment.
- Policy recommendations by country situation:
  - Limited and stable dollarization: ensure prudential norms internalize credit risk of dollar loans.
  - Substantial dollarization (consistent with MVP): proactive de-dollarization focusing on internalizing risks, promoting local currency markets, and building monetary credibility via institutional reforms and capacity building.
  - Corner equilibrium (FD above MVP): switch toward more symmetrical and less constrained monetary policy (e.g., inflation targeting), tighten prudential standards to increase resilience, and consider more aggressive measures to limit dollarization as a complement to monetary reforms.
  - Where credibility consolidation is slow: promote price-indexed instruments and market-based measures to smooth transition costs.
  - Highly dollarized countries that can maintain a bi-currency regime: prioritize building prudential buffers and weigh buffer costs against benefits of exchange rate flexibility.
  - Small, widely open countries in an optimal U.S. dollar currency zone or with exhausted credibility options: consider de jure dollarization.
- Diagnostic first step:
  - Undertake research to understand roots of dollarization, its risks and costs, benefits of de-dollarizing versus fully dollarizing, and implications and calibration of policy and prudential reforms.
  - "Understanding the complexity of the phenomenon and its important economic implications is a natural first step."

*Source: _wp05187.*

### References..............................................................................................................

### _wp05187 - References

### I. INTRODUCTION
- Recent events and trends have intensified concerns about financial dollarization (FD):
  - mounting evidence that FD has increased or remained stable despite declining inflation rates.
  - dollarization has complicated the policy response in several crises and near-crisis episodes, and, in some cases, has been singled out as the source of financial vulnerability that triggered a crisis.
  - the widespread shift from fixed to more flexible exchange rate regimes has altered the policy landscape, highlighting the prudential consequences of exchange rate risk.
- These developments have heated up the policy debate about de-dollarization: Is de-dollarization a realistic goal? Is it worth the trouble? If so, how can it be pursued?
- The paper aims to summarize the ongoing debate and where we stand.

### Focus and definitions
- The paper focuses on de facto (unofficial) dollarization, defined as the holding by residents of assets and liabilities denominated in a foreign currency that does not enjoy legal tender status.
- The emphasis is on:
  - domestic dollarization (namely, financial contracts between domestic residents such as onshore deposits and loans) rather than external dollarization (financial contracts between domestic and external residents such as external bonded debt), and
  - asset-liability dollarization rather than on currency substitution (that is, the use of the foreign currency for transaction purposes).
- Note: "However, there are some important points of intersection between external and domestic FD (including the fact that holders of external dollar assets are typically unknown) and between asset and currency substitution (including the fact that interest bearing assets also provide liquidity services) that cannot be ignored."3

### Central questions addressed
- How much do we know about the causes and dynamics of de facto dollarization?
- What are the key strategic policy options? Should countries—
  - aggressively seek to de-dollarize and, if so, should de-dollarization be viewed strictly as a by-product of good economic management (combat the causes rather than the symptoms) or should it be pursued as a goal in itself (which may require direct action to limit or reverse dollarization)—?
  - accept dollarization but learn to live with it by limiting its downsides and improving policy within the confines of a dollarized environment (better to bend than to break)—?
  - call it quits and fully (officially) dollarize?

### Road map and tactical issues for further discussion
- The paper sets the stage for more detailed and focused discussions on key tactical issues:
  - how (and how aggressively) to de-dollarize;
  - how to conduct monetary policy in a dollarized economy (and how to vanquish fear of floating);
  - how to implement prudential reform; and
  - how to promote local currency markets.
- Section structure:
  - Section II: reviews existing theories of de facto dollarization.
  - Section III: examines empirical evidence and differentiation between competing theories.
  - Section IV: discusses the costs and risks of dollarization.
  - Section V: presents the main strategic options for reform.

*Source: _wp05187 - References.*

### Section VI concludes by proposing a list of policy recommendations as a function of the type

### _wp05187 - Section VI concludes by proposing a list of policy recommendations as a function of the type

### Theories of Financial Dollarization — overview
- Financial dollarization (FD) is an equilibrium outcome of currency composition choices in loan contracts; unlike payments dollarization, FD is driven by risk differences rather than systematic rate-of-return differentials.
- Three conceptual categories of FD origins:
  - The Price Risk-Portfolio Paradigm (portfolio/CCAPM approaches).
  - The Credit Risk Paradigm (perfect information, imperfect information, moral hazard/prudential regulation).
  - The Financial Environment (market size, integration, market and legal imperfections).

### A. Price Risk–Portfolio Paradigm — key mechanisms and implications
- Core assumption: uncertainty of real returns (price risk) drives currency choice under risk aversion; variants include CAPM and CCAPM formulations.
- CAPM-style results:
  - Agents choose currency composition to optimize risk-return measured in local consumption units.
  - In the simplest setup, supply-demand in each currency leads to uncovered interest rate parity (UIRP) and a minimum variance portfolio (MVP) allocation.
  - In absence of rebalancing costs, what matters is relative volatilities of inflation and real exchange rate depreciation, or the covariance-of-inflation-and-exchange-rate relative to their variances (the “beta”).
  - The dollar is preferred if the real exchange rate is stable relative to the inflation rate.
- With rebalancing costs, relative volatilities of peso and dollar real interest rates determine currency choice; the dollar is preferred if dollar interest rates are more stable.
- Implications:
  - Monetary policy that fails to stabilize inflation or that targets the real exchange rate can stimulate dollarization.
  - FD should increase with degree of openness and presence of real dollarization (dollar pricing) due to higher pass-through.
  - Resident savers/borrowers favor local currency because peso instruments better mirror future consumption/income streams; real assets indexed to CPI minimize variability of real returns.
  - Expectations and credibility matter: fully credible exchange rate pegs leave dollarization undetermined; lack of credibility makes expected distributions of exchange rate and inflation after a regime collapse decisive, inducing persistence (hysteresis) in FD.
- CCAPM extension:
  - Introduces a safe-haven effect: when consumption is negatively correlated with exchange rate, investors tilt toward the dollar.
  - Economies hit by sudden stops or political disturbances (sharp downturns with depreciations) likely exhibit stronger dollar preference.
  - Interaction with real dollarization: foreign currency–denominated wages/prices raise pass-through and FD.

### B. Credit Risk Paradigm — channels and policy lessons
- Shifts focus to decisions of risk-neutral agents under default risk; market imperfections shape outcomes.

- Perfect information case:
  - Creditors internalize credit risk; ex ante returns (including expected defaults) equalize across currencies.
  - Debtors (limited liability) prefer the currency minimizing expected bankruptcy costs.
  - Dollar preferred when probability of devaluation is small yet peso premium makes peso loans costlier, inducing interest-rate-induced credit risk.
  - “Fear of floating” or pegged regimes can increase nominal peso rates and interest-rate risk, strengthening dollar dominance.
  - Monetary policy endogeneity: once dollarized, authorities may favor a peg to avoid balance-sheet stress, biasing exchange rate distribution toward small changes and occasional large depreciations (long positive tails), producing corner equilibria (full dollarization or full pesification) and hysteresis.
  - Policy takeaway: allowing more exchange rate flexibility can alter relative risks in favor of the peso; reducing liquidation costs (shorter bankruptcy, lower judiciary costs, less corruption) can reduce FD by limiting fear of floating.

- Imperfect information case:
  - Creditors cannot observe borrowers’ currency exposure and choose strategically, potentially producing corner solutions (full dollarization or pesification).
  - Pro rata distribution of residuals in default states dilutes peso claims more than dollar claims when default correlates with high exchange rate; this dilution favors dollar claims and incentivizes dollar lending.
  - Root cause: market failures (coordination, information), implying marginal policy reforms may be ineffective.

- Moral hazard and prudential regulation:
  - Deposit guarantees, bailouts, central bank foreign liquidity support create option-like incentives favoring dollar intermediation because dollar positions maximize option value of implicit guarantees.
  - Currency-blind prudential regulation (uniform deposit insurance, standard LOLR) and failure to account for currency mismatch in capital requirements further favor dollarization.
  - Policy takeaway: ensure risks are internalized via proper prudential requirements that reflect currency-specific risks to mitigate dollarization incentives.

### C. Financial Environment — structural determinants
- Size and integration:
  - More open and internationally integrated countries should be more dollarized; small countries may be especially dollarized due to exposure to world shocks and limited benefits of an independent currency.
  - Empirical evidence links economic size to external FD but not consistently to domestic deposit dollarization.
- Market and legal imperfections:
  - Efficiency asymmetries and offshore intermediaries that intermediate only in dollars induce “offshorization,” compress dollar margins and raise peso margins.
  - International markets may be inaccessible in local currency due to liquidity risk, transaction costs, network effects, and benchmark practices favoring major currencies.
  - Legal factors: lower liquidation costs, better creditor rights offshore enhance dollar attractiveness.
  - Policy implication: leveling the playing field—remove distortions, promote local currency markets, improve legal and regulatory frameworks—can justify government intervention; however, constraints of market size and hysteresis from established dollar markets complicate transitions.

### Empirical evidence — what supports each paradigm
- MVP-based explanations:
  - De Nicoló, Honohan, and Ize (2003) and Levy Yeyati (2005) find cross-country evidence that MVP explains a significant share of FD at the expense of inflation rate, supporting portfolio models.
  - Trade openness often insignificant in static cross-country regressions; size matters for external but not domestic deposit dollarization.
  - Observed pass-through correlates with FD but elasticity < 1, implying MVP explains only part of FD; excess dollarization remains.
  - Long-sample MVP measures perform better than recent-sample measures, suggesting expected (not just observed) volatilities/credibility matter.
- Evidence beyond MVP (corner solutions):
  - Positive statistical link between dollarization and fear of floating (directionality not established).
  - Some evidence of asymmetric/skewed nominal exchange rate distributions explaining dollar dominance.
  - Correlations between exchange rate and output negative in highly dollarized economies support credit-risk and safe-haven mechanisms.
  - Large borrowers tend to be more dollarized (coordination failure hypothesis), but alternative explanation is narrow peso funding for large borrowers.
- Prudential/moral hazard evidence:
  - Currency-blind prudential regulation correlates with greater FD (Cowan, Kamil, Izquierdo, 2004).
  - Restricting or eliminating LOLR induces banks to hold more liquidity (Gonzalez-Eiras, 2003).
  - Evidence on capitalization and dollar intermediation is limited and circumscribed.

### How concerned should countries be? — monetary effectiveness and balance-sheet risks
- Monetary policy effectiveness:
  - FD has not prevented inflation stabilization when exchange rate acts as flexible anchor; FD remained high despite lower inflation.
  - FD associated with higher exchange rate pass-throughs, which can limit monetary policy flexibility and countercyclical capacity.
  - Interest rate transmission is diluted when intermediation occurs predominantly in dollars; monetary policy can still operate via the exchange rate (e.g., crawl), but large exchange rate moves can harm borrower balance sheets.
- Balance sheet effects:
  - FD raises prudential concerns: increased local-currency value of dollar liabilities can outpace asset/income values, triggering corporate/banking crises, sudden stops, and output volatility.
  - Empirical associations:
    - Dollarized countries have more fragile corporate sectors and banking systems (Claessens and Djankov, DHI).
    - Greater exposure to contractionary devaluations, devastating sudden stops, public debt crises, and banking crises.
    - Higher output volatility in dollarized countries (Reinhart, Rogoff, and Savastano; Eichengreen, Hausmann, and Panizza; LY).
  - Net: FD increases crisis propensity and can limit effectiveness of countercyclical monetary policy in large shocks.

### Market-driven road to de-dollarization — principles and policy instruments
- De-dollarization makes most sense where dollarization persists despite sound monetary/fiscal policy and improving institutions; broad, far-reaching agenda required where hysteresis exists.
- Two main fronts for market-driven de-dollarization:
  1. Revise regulation to fully internalize risks of dollar intermediation and provide more room for monetary policy.
  2. Promote use of peso and peso-based substitutes to the dollar.
- If FD approximates MVP (interior solution):
  - Improving monetary credibility should reduce dollarization.
  - Policy focus: institutional and capacity building to improve central bank’s independent, sound monetary policy; but building credibility is slow and politically costly.
- If FD exceeds MVP (corner solution; coordination failures, information problems):
  - Improving transparency may help marginally, but high correlation of default and devaluation in highly dollarized economies makes switching regimes alone insufficient.
  - Prudential reform can increase banking resilience (e.g., tighter norms on dollar loans to nontradable sector) but main goal should be immediate financial stability rather than altering FD.
  - Transition risks: raising prudential requirements can induce disintermediation or migration to alternative (possibly riskier) intermediation channels, potentially offshore and dollar-based; regulatory arbitrage must be addressed.
- Policy instruments and sequencing to promote peso use:
  - Improvements in monetary management (procedural changes to stabilize peso interest rates and increase transparency).
  - Refocus public debt management toward peso-denominated instruments to deepen local currency markets.
  - Price indexation as an intermediate step:
    - Indexed pesos (real rates) can bridge from dollars to pesos, by eliminating inflation-expectation component of peso premium at longer maturities.
    - Limitations: indexed pesos may fall in value upon currency adjustment (backward-looking indexation), limited liquidity in crises, slow market acceptance requiring substantial public-debt-management support.
    - Indexed instruments are more viable when accompanied by a radical monetary-policy switch (e.g., to free float) and active regulatory policies that make indexed/peso instruments appealing; development of peso bond markets is critical for pricing and trading.
- Prudential policy guidance during transition:
  - Prudential norms should reflect actual regime: imposing alternative-risk-based capital/limits without regime credibility risks inappropriate distortions.
  - During constrained monetary regimes, prudential requirements may need to be raised for both peso and dollar exposures to preserve stability.
  - Authorities should anticipate regulatory arbitrage and design measures to eliminate profitable shifts to offshore/dollar intermediation.

*Source: _wp05187 - Section VI concludes by proposing a list of policy recommendations as a function of the type*

### introduction and promotion of price indexation could be viewed as an unnecessary and costly

### _wp05187 - introduction and promotion of price indexation could be viewed as an unnecessary and costly detour

### B. Should Countries Fight Dollarization Frontally?
- There is no consensus on whether to pursue market-driven de-dollarization or to fight dollarization frontally; measures to directly discourage dollarization cited include limits on dollar deposits or loans, taxes on dollar intermediation, and forced conversion.
- Direct measures could "speed things up (and hence reduce transition costs) by cutting through the policy coordination maze."
- Conventional wisdom warns that overnight (de jure) de-dollarization may be risky and ultimately costly unless up-front measures boost credibility simultaneously (or preferably ahead of time).
- Forcing agents to use a currency they distrust could lead to:
  - heavy disintermediation or risk shifting (de la Torre and Schmuckler, 2004),
  - undermined political support for frontal attacks on dollarization absent a crisis,
  - potential runs on deposits if political support is mobilized by scaring the public.
- Historical experiences:
  - Bolivia and Peru during the 1980s: central bank forced removal of restrictions led to rapid re-dollarization.
  - Mexico in 1982: forceful de-dollarization led dollar intermediation off-shore via capital flight and external borrowing by large corporations; may have helped set the stage for a later comeback of the peso following strong improvements in monetary policy credibility.
  - Pakistan and Argentina: compulsory conversions and subsequent restrictions on dollar intermediation are "still too recent to judge" but "may ultimately facilitate the growth of a more healthy and ultimately deeper local-currency-based intermediation."
- Empirical counterpoint: the view that dollarization contributes to financial deepening is contradicted by evidence; "if anything the link is negative, and the effect of legal restrictions beneficial (DHI, LY)."
- Policy trade-offs:
  - A gradual approach that only aims at putting some "sand in the wheels" of dollarization is less risky but may yield meager results.
  - The slow pace of reform and possible policy interruptions/reversals raise the question whether a more forceful approach, backed by stronger policy commitment, is desirable—especially in very highly dollarized countries.
- Political economy:
  - When there is a clear consensus and backing for a drastic policy shift, a frontal assault may be possible.
  - Ideally, enhance monetary policy credibility prior to drastic measures; in practice, a crisis may be needed to generate support, though lack of monetary credibility in a crisis creates the risk that a central bank must "jump boats at mid-course" without an established reputation.

### C. When Is It Time to Give It Up?
- Some heavily dollarized countries that are small, have narrow markets and large tradable sectors, and whose central banks have low credibility and/or limited technical resources, may find radical reform too costly.
- Policies designed to ease the pain of dollarization can unintentionally undermine political support for regime change, potentially making dollarization irremovable.
- Alternative: a bi-currency regime (currency board) as an alternative to full de jure dollarization.
  - Benefits of a bi-currency system:
    - Allows central banks to retain seignorage benefits.
    - Provides room (through altering the rate of crawl) to speed up required adjustments in the real exchange rate, thereby limiting output volatility and associated financial stress.
    - If inflation is kept low, theoretical and empirical support suggests real exchange rates can be depreciated without inducing substantial inflation.
  - Costs and requirements:
    - Continued dollarization maintains risks of financial stress; limiting vulnerabilities requires adequate prudential buffers (solvency and liquidity), which come at a cost.
- De jure dollarization:
  - Also requires buffers.
  - Advantage: limits scope for "forced" devaluations resulting from self-fulfilling twin crises (a banking crisis culminating in a currency crisis/devaluation).
  - Preferable when welfare costs and heightened financial vulnerability from increased output volatility and exposure to output shocks are more than offset by reduced exposure to self-fulfilling liquidity crises and resulting reduction in interest rates.
- Policy guidance on regime choice:
  - De jure dollarization may be appropriate for countries that are part of an optimal U.S. dollar currency zone or have exhausted options for monetary credibility and/or financial stability.
  - Other countries may be better off with a bi-currency regime until clearer currency areas (dollar or regional) emerge.

### VI. Conclusions
- High-level conclusions:
  - Dollarization can no longer be systematically viewed as unavoidable and inconsequential.
  - Countries should formulate a comprehensive and well-coordinated policy agenda to deal with dollarization and its risks.
  - The policy agenda should be a function of the type and extent of dollarization and the macroeconomic, institutional, and structural constraints facing the economy; these constraints determine whether de-dollarizing is an option and how it can be achieved, or whether the agenda should focus on containing dollarization risks without seeking to reduce dollarization.
- Dollarization is not uniformly negative:
  - Some dollarization may be desirable.
  - Countries with no dollarization due to legal restrictions but credible monetary policies may consider liberalizing dollar accounts for efficiency reasons, under a suitable prudential environment.
- Policy recommendations by country situation:
  - Countries with limited and stable dollarization: ensure prudential norms internalize credit risk of dollar loans.
  - Countries with substantial dollarization: consider a proactive de-dollarization strategy that focuses on internalizing risks, promoting local currency markets, and building monetary credibility through institutional reforms and capacity building—when FD is consistent with "warranted" MVP dollarization.
  - Countries in a "corner" equilibrium where dollarization is above MVP:
    - Preferred strategy is to switch towards a more symmetrical and less constrained monetary policy (such as an inflation-targeting regime), supported by tightened prudential standards to make the financial system more resilient to exchange rate volatility.
    - More aggressive measures that directly limit dollarization might be appropriate to help vanquish fear of floating and speed up the transition, but only as a complement to monetary reforms, not as a substitute.
    - Less intrusive, market-based measures, such as the promotion of price-indexed instruments, can help speed the transition and smooth costs; these are particularly advisable where consolidating monetary credibility is expected to be slow.
  - Highly dollarized countries where credibility cannot be substantially improved but that can maintain a bi-currency regime: argue for "learning to live with FD," which entails building sufficient prudential buffers so exchange rate flexibility can be used without causing excessive financial stress; weigh the cost of buffers against benefits of greater exchange rate flexibility.
  - Small, widely open countries that are part of an optimal U.S. dollar currency zone or have little room to improve monetary credibility and financial stability may be better off switching to de jure dollarization.
- Diagnostic first step:
  - Dollarized countries should undertake research to understand the roots of their dollarization, its risks and costs (and benefits of de-dollarizing versus fully dollarizing), and the implications and calibration of policy and prudential reforms.
  - "Understanding the complexity of the phenomenon and its important economic implications is a natural first step."

*Source: _wp05187 - introduction and promotion of price indexation could be viewed as an unnecessary and costly*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp05187.pdf_